Initial Reaction to Bernanke: USD and US Assets Firm

As the draft of Fed Chairman's Bernanke speech at Jackson Hole made the rounds, the US dollar as pared back some of its earlier losses, US yields have eased and equities retraced part of the opening losses. However, the dollar quickly was sold and many of the major currencies have made new highs on the day, though stocks and bonds are maintaining their initial reactive gains. Bernanke's speech appears to justify past asset purchase programs. He cited one study that suggests these efforts may have helped boost GDP by 3% and help create 2 mln jobs. He recognizes the risks of additional purchases, but believes those risks are manageable. He explicitly is not ruling out additional asset purchases as required to support growth and, of course, the labor market, remains a "grave concern". However, Bernanke is not committing the Fed to a new round of asset purchases at this juncture. He does sketch out the economic challenges, but stops shy of advocating a particular response. Next week's US employment report is still key. On balance, the data since the last FOMC meeting point to stronger Q2 growth than was evident at the time and somewhat better Q3 growth. Global impulses are also not very favorable. China's data has generally disappointed and the official PMI will be released over the weekend. Falling iron ore and steel prices seem to be more telling than any piece of official data. Japan's economy appears to be slowing from the reconstruction expansion quicker than previously appreciated. Most evidence suggests that the euro zone economy is contracting here in Q3 and that the German economy will be lucky to simply stagnate. Our general view remains intact and still expect the dollar to recover as the focus shifts back to Europe and we note into the European close, Spanish bonds are getting whacked, with 10-year yields rising over 20 bp to the highest yield since Aug 14. As we noted earlier this week, the credit-default swaps have generally presaged the sell-off in Spanish bonos and are making new multi-week highs too. While we continue to lean against QE3 at the next FOMC meeting, we also recognize that the dollar has tended to rally after such an announcement is made. That the headlines will read that Berannke does not rule out additional asset purchases is factually correct, but tells us nothing new. Bernanke has never ruled it out. Why should he? Under the Fed's view, it has been successful. With the Fed funds rate near zero, unconventional measures may still be needed. It is unreasonable to expect a unilateral disarmament. The type of accommodation we expect from the FOMC is in its guidance and continued conduct of Operation Twist. A cut in the interest on excess reserves and/or a new lending facility (which we are sympathetic to) seem decidedly less likely. Even if we are wrong about QE3, the outlook for the dollar may not change. As we have noted countries that have expanded their balance sheets have not necessarily seen their currencies weaken (the euro zone being an exception) and the dollar has tended to rally after an asset purchase program is announced.